Greentown Service Group Co Ltd (SEHK:2869) outperformed the Diversified Support Services industry on the basis of its ROE – producing a higher 33.51% relative to the peer average of 14.16% over the past 12 months. Superficially, this looks great since we know that 2869 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 2869 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 2869’s ROE is actually sustainable. View our latest analysis for Greentown Service Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Greentown Service Group’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.34 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Greentown Service Group, which is 8.38%. Given a positive discrepancy of 25.14% between return and cost, this indicates that Greentown Service Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Greentown Service Group’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Greentown Service Group’s debt-to-equity level. Currently, Greentown Service Group has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.